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July 2, 2013

Viewing Interest Rate Volatility Risk Through an Options Lens

Fixed income investors have recently expressed fears that U.S. interest rate increases are closer than originally expected after Fed Chairman Bernanke’s comments at a Congressional hearing that led to a dramatic sell-off in the bond market.

The 10-year Treasury yield entered the month of May with a yield of 1.64% and reached 2.21% by June 10th. Interest rate volatility has also increased since the May 22nd hearing.

Through May, taxable bonds had experienced over $110 billion in net inflows, according to Morningstar. Only recently, however, have flows into fixed income mutual funds turned negative. On June 19th, Lipper reported $17.7B in outflows to date in the month. Investors that were demanding greater yields are now showing signs of nervousness. The question facing these investors is where best to allocate the funds sourced from a bond portfolio. More importantly perhaps, in an environment where investors have sought anything providing yield, which assets are best suited to replace the lost income stream without incurring additional portfolio volatility?

The recent marketplace has clearly been a Pandora’s Box for income-seeking investors. Investors fearful of rising rates and looking to sell fixed income holdings may choose to allocate to equities, invest in alternatives or hold cash. Each carries its own set of risks as described below.

Although inflation fears have subsided, the choice of allocating to cash is effectively guaranteeing a negative real rate of return (nominal return less inflation). Though many cautious institutional managers have chosen this route, many retail investors are dependent on income and locking in a zero yield is not an option. Some investors will choose to stomach the price volatility of their bond portfolios to maintain a stable level of income and refuse to rotate into equities or cash. Others may consider a third choice by adding alternative exposure to their portfolios.

Market returns would tell you that the default answer for flows has been equities, as the S&P 500 Index has increased more than 3% since the beginning of May. That performance has not been without a significant increase in volatility, however. The most common measure of volatility, the VIX, has increased 27% over the same time period. (May 1-June 14)

Let’s also not forget that the U.S. equity market, as measured by the S&P 500 Index, is up 15.3% year-to-date (again through June 14) and now yields less than 2%. Investors allocating to equities would be “chasing” a 15% return while adding to portfolio volatility. Some income investors in the past few weeks have made the mistake of moving their fixed exposure to dividend- paying equities as a “bond proxy.” In this scenario, the investor is potentially exacerbating the same interest rate risk he was aiming to avoid, while increasing the inherent volatility by allocating to equities.

From an options perspective, dividend-paying stocks have exhibited the greatest relative volatility in the S&P 500 Index. As evidence, since longer-dated bonds spiked in late May, high-yielding stocks including REITs and MLPs have sold off in unison, some by over 15%.

Options as a Fixed-Income Alternative?

While many fixed-income “alternatives” exist, including long-short and market neutral strategies, an alternative strategy that has begun to attract a wider swath of investors utilizes options to remain correlated to equities while also hedging out the volatility of existing equity portfolios. For most, the objective of fixed income is yield; for others, the goal is to dampen the volatility of their equity portfolio. Options offer the possibility to do both.

Increased volatility in the fixed income marketplace has started to make the equity options universe attractive from a relative basis for several reasons.

First, investors can minimize the interest rate risk that is causing the price volatility in their fixed income portfolio. Second, options portfolios can be designed to smooth out the volatility of an equity portfolio, while offering investors correlated equity market returns with fixed income like volatility. Third, options premiums can provide a level of income that supplants some of what was lost from the bond allocation.

In a world of heightened yields and interest rate volatility, investors should be careful about the risks and rewards of selling bonds and reallocating to traditional equities or cash. A byproduct of funding equity exposure from your fixed income portfolio could be an increase in portfolio volatility. However, with a diversified options portfolio, investors can add exposure to the equity market while maintaining a much lower volatility than buying stocks or equity mutual funds.